An Economic Analysis of Libel Law

Author(s): Manoj Dalvi and James F. Refalo

Source: Eastern Economic Journal , Winter, 2008, Vol. 34, No. 1 (Winter, 2008), pp. 74-
94
Published by: Palgrave Macmillan Journals

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 \?s Eastern Economic Journal, 2008, 34, (74-94)
Tjv ? 2008 EEA 0094-5056/08 $30.00
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An Economic Analysis of Libel Law

Manoj Dalvia and James F. Refalob
aC. W. Post Campus, Long Island University, 720 Northern Blvd., Brookville, NY 11548, USA.
E-mail: mdalvi@liu.edu
California State University, 5151 State University Drive, Los Angeles, CA 90032, USA

This paper examines the welfare implications of different libel law standards as applied to
newspapers in publishing stories. Our work extends the current literature by permitting
private and public incentives to deviate, giving rise to an agency problem, and by
formulating a two-stage decision model based on a story's expected value. We show that
the negligence standard provides incentives for the agent to take actions, merely to insure
itself against liability. This results in a deadweight loss to society. We also show that both
standards can be socially inefficient; however, correction using policy tools under strict
liability places a lower informational burden on policy makers, than does the negligence
standard.
Eastern Economic Journal (2008) 34, 74^94. doi.T0.1057/palgrave.eej.9050003

Keywords: agency; welfare; externality; negligence; liability; decision; deadweight loss;

subsidy; expected value

JEL: D61; D62; D81; K00

INTRODUCTION
This paper examines the welfare effects of different libel law standards as applied to
the publication of news stories about public figures. Because of public (social)
externalities, not all benefits or costs stemming from publication accrue to, or are
borne by, the newspaper. As a result of these distortions, the socially optimal
solution is unlikely to obtain.
The paper models the application of libel law by assuming that the newspaper's
decision to publish is determined by the expected liability (costs) arising from
publication of false stories, where its ability to mitigate some of the costs depends on
the applicable liability standard. We show that compared with strict liability, the
current standard governing libel law ? termed "negligence" ? leads to greater
publication costs for stories that are likely to be true and potentially increased
publication of stories that are likely to be false. This result is due to additional
liability protection provided by negligence, enabling a newspaper to "insure" against
liability.
We also show that an implicit agency problem exists between the newspaper
and society under both standards, and determine conditions for which the
social optimum can be consistently attained under strict liability, when using
conventional policy tools. We demonstrate that the negligence standard cannot be
adjusted in a similar manner. Finally, we provide other applications for this
modeling approach.
Prior to 1964, the legal rule governing libel in the United States was a "strict
liability" standard, under which a newspaper would be liable for all damages caused
to someone's reputation by any story that was not provably true.1 In its decision of

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An Economic Analysis of Libel Law *7tV
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New York Times v. Sullivan,2 the Supreme Court ruled that "a public official cannot
recover damages for a defamatory falsehood unless he proves that the statement was
made with "actual malice," ? that is "with knowledge that it was false or with
reckless disregard of whether it was false or not."3 It thereby reduced the range of
stories for which a newspaper could be found liable. In 1967, the Supreme Court
extended this protection to stories about public figures.4 Thus, a negligence-style
standard now governs libel suits brought by public officials or public figures.5
The motivation for this paper is to analyze implications for public welfare of these
different liability standards in the presence of public externalities. Libel is an
example of a "single activity accident" [Brown 1973; Diamond 1974], such that the
actions of a newspaper damage an individual.6 For single activity accidents, a strict
liability standard in the absence of other externalities is generally efficient [Shavell
1980; 1987]. Such models examine cases in which the only externality from an
activity is the harm done to a third party.7 However, publishing news about public
issues is deemed to entail a positive externality.8 The concern with a strict liability
standard for libel is a potential chilling of publication and concomitant reduction of
this externality.9 If publishers internalized all benefits from their activities and the
only distortion was the negative externality from libel, this would not be of any
concern. Since conventional tort models typically assume the party will internalize
all benefits and costs other than third-party damages, it is important to consider
some deviation from those assumptions in order to assess whether the New York
Times v. Sullivan standard is appropriate.
The model in this paper will allow for the possibility that, absent any libel, the
social value of publishing differs from the private incentive.10 We do this by
assuming that the newspaper pursues policies that maximize expected value, and
that the costs and benefits from publication differ from those of society. Such an
assumption implies that a strict liability standard, by itself, does not result in the
social optimum. However, we show that in theory we can adjust the strict liability
standard using policy tools so that the problem solved by the publisher is
proportional to that needed to maximize public welfare. In contrast, the negligence
standard will fail to attain the social optimum even with the use of policy tools.
We extend the existing liability literature and study the distortions caused by
liability rules in a two-stage decision model where the newspaper has the option to
obtain further information regarding the truthfulness of a story, and we allow
abandonment of the activity.11 The former permits a revision of the expected value
of a story; the latter allows a story to be pursued that would otherwise not be
sufficiently plausible to publish under a strict liability standard. Permitting
investigation also allows us to examine the qualitative differences between the two
liability standards, namely that under negligence, investigation permits a publisher
to inure itself against liability. Using the two-stage model we are able to define
regions governing the actions of the publisher based on the ex ante (or perceived)
probability that a story is true.
The remainder of the paper is organized as follows. The next section discusses the
details of the model and derives the probability boundaries that are central to the
model and govern the publishing decisions of the newspaper. The subsequent section
derives the welfare equation and examines the deviation from the social optimum
created by the agency problem. This section also develops the conditions under
which policy tools can be used to correct for agency, and discusses policy
implications. The penultimate section provides applicable extensions. The final
section presents the conclusions.
Eastern Economic Journal 2008 34

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THE MODEL
General setup and assumptions

General setup
Assume that a newspaper has access to a number of newsworthy stories, and that
each has a perceived probability of being true.12 The newspaper has three potential
actions with regard to each story: publish without investigation, investigate, or kill.
If the newspaper chooses to investigate, then it will publish or kill the story based on
the results of the investigation. The decision tree of the newspaper is given in
Figure 1. The newspaper is assumed to face one of two liability standards: strict
liability or negligence. To determine the chosen action, we compute the expected
value of the actions given the liability standard, and then determine the range of
probabilities over which each action is optimal for the newspaper. We then compare
standards by comparing the range of probabilities over which the actions are taken.

Assumptions and notation

Each story is assumed to have a probability p of being true, where f(p) is the
corresponding distribution of p for stories being considered by the newspaper.13 If
the newspaper publishes a true story, it obtains benefit v > 0. If it publishes a false
story, it suffers a loss d > 0, which is independent of any liability. We can think of the
benefits and losses as stemming from increases/decreases in circulation or
advertising revenue that can be attributed to the publication of a story. If the
newspaper publishes a false story, it may also be liable for damages to the individual,
Dh depending on the liability standard.
The newspaper has the option of investigating a story for a cost C. The
investigation will signal that a story is "true" or "false," and based on that signal,
the newspaper chooses to "publish" or "kill" the story.
Investigation is assumed to be imperfect, and can yield an incorrect signal about
the truth of a story. Let a be the probability that the investigation will signal that a
true story is "false," and ? be the probability that the investigation will signal that a
false story is "true." Assume that a<0.5 and that ?<0.5.
The first standard we consider is termed "strict liability," where the newspaper
incurs liability damages if it publishes a false story. The second standard is termed
"negligence."14 The Supreme Court's definition of negligence is "with knowledge
that [the story]... was false, or with reckless disregard of whether it was false or not."
To reflect this in our model, the newspaper incurs liability damages under negligence

Publish Publish

Kill Kill

Figure 1. Actions of the newspap

newspaper. The newspaper can pub
updates its probability, and then d
regime that confronts the newspape

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77

only when it publishes a false story when the investigation has signaled that it is false,
or publishes a false story that has not been investigated.15 The newspaper does not
incur a liability if it publishes a false story that it has investigated when the
investigation has signaled that the story is true.

Newspaper actions

Since the newspaper receives benefits from publishing a true story and incurs
damages when publishing a false story, the expected value of each story is a function
of the liability standard, the story's probability, and the action taken. Thus, given a
liability standard and a probability, the newspaper must decide whether to publish
without investigation, investigate, or kill a story, in order to maximize the story's
expected value:
(1) V(p) = Max{EV(Publish W/O), EV(Kill), EV(Investigation)}
The intuition is straightforward. At date 0, the newspaper takes the action yielding
the maximum expected payoff for a story with a probability p of being true. For
example, a decision to publish without investigating means that the expected payoff
from that action is greater than the expected payoff from killing or investigating (less
the cost of investigation).
To determine the range of p over which each action is optimal, we compute two
boundary equations (probability bounds): a lower bound for p along which the
newspaper is indifferent between investigating and killing a story, and an upper bound
along which the newspaper is indifferent between investigating and publishing a story.
These boundaries are determined by equating the expected values for the alternative
actions, and solving for the corresponding p. The newspaper thus kills all stories with
p below the lower bound, and publishes all stories with p above the upper bound. It
investigates all stories with p between the two bounds.
Regardless of the liability standard, if the newspaper kills a story, then there are
no expected benefits, damages, or investigation costs: the expected value is 0.
Likewise, regardless of standard, if it publishes without investigation, there are no
investigation costs, so the expected value is the expected benefits of publishing a true
story less the expected damages from publishing a false story:
(2) EV(Publish W/O) ? pv - (\ -p)(d + Z>/)
However, because the negligence standard provides liability protection when stories
are investigated, and strict liability does not, the expected value of investigating a
story (and corresponding probability bounds) must be determined contingent on a
standard. The next two sections develop respectively the expected value of
investigation subject to strict liability and negligence, and compute the correspond
ing probability bounds determining the newspaper's actions.

Strict liability
Under a strict liability standard, a story will only be published after investigation
when the investigation signals that the story is true.16 Thus, the expected value from
investigation is the expected benefit from publishing a true story, less the expected
damages from publishing a false story, less the cost of investigation (for proof, see
appendix; payoffs for the decision tree are illustrated in Figure 2):17

(3) EV^(Investigation) = p(\ - a)v - (1 -p)?(d + D7) - C

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 \1/ Manoj Dalvi and James F. Refalo
VfV An Economic Analysis of Libel Law
78

pv - (1 -p)(d + Dj) (I- ot)p(v -O- ?(l-p)(d + D7 - O

0 (ocp + (l-?)(l-p))(0-C)

Figure 2. Actions of the newspaper. There are three potential actions for the newspaper under strict
liability. The actions are kill the story without investigation, publish without an investigation, or
investigate and publish if the investigation signals that the story is true. The payoffs to the newspaper for
these actions are illustrated by the following diagram.

Publish Without
Investigation

Pc>c's

Figure 3. Actions of the newspaper under strict liability. The figure summarizes the optimal actions of the
newspaper regarding a story with a probability (/?) of being true under a strict liability standard. The
newspaper's action is determined by the relationship of p to the probability bounds pj and p". No
investigation occurs for C>CS".

To establish the lower bound for which an investigation is undertaken (/?/), we

equate (3) with the expected value of "killing" the story (zero), and solve for the
probability:
(4) p{\ - a)v - (1 -p)?{d + /)/)- C = 0
Likewise, to obtain the upper bound on p for which investigation is optimal (p"\ we
equate (2) with (3) and solve for the corresponding probability:
(5) pv - (1 -p)(d + Dj) = p(\ - a)v - (1 -p)?(d + Dj)C

When a story's probability lies below pj, it is not sufficiently plausible to

investigate given the expected costs and benefits, and is immediately "killed" by the
newspaper. Above the story is so credible that the newspaper publishes the story
without investigation. The reason is that the cost of investigation exceeds the
expected damages from publishing a false story; thus, it is economically inefficient to
investigate. Finally, in the region between pj and /?/, an investigation is conducted.
The story is "killed" if the signal is false, and it is published if the signal is true.18
Figure 3 summarizes the actions of the newspaper under strict liability.
Note that pj slopes upward in C ? as investigation costs increase, so does the
minimum p for which EV(Investigatiori) > 0. Likewise, p" slopes downward in C
because the maximum p for which EVs(Investigatiori) > EV(Publish W/O) declines.
Because these bounds converge, there is an upper bound on the cost of investigation
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 Manoj Dalvi and James F. Refalo
An Economic Analysis of Libel Law
79

(C/), beyond which it is economically sub-optimal to investigate any story. C" is

determined by equating pj with p", and solving for C.
The optimal action under strict liability is summarized in the following
proposition:19

Proposition 1 Assume that the newspaper is subject to a strict liability standard;

then there is a lower bound, pj (that is positively sloped in C), and an upper
bound, p" (that is negatively sloped in C), such that the newspaper will: kill
a story when p<ps\ publish the story without investigation when p>ps", and
investigate the story and publish only if the investigation signals the story is true,
whenPs <P<Ps'- Defining C" as the value of C at which pj andp" converge to
a single boundary Pc>c"si when C/, the newspaper will publish all stories for
P>Pc>c"s and kill all stories for p^Pc>c"s

Proof See appendix.

Negligence
The qualitative results under a negligence standard are similar: there is, however, a
significant difference. Because the newspaper is absolved of liability when it
investigates and receives a signal that the story is true, two more probability
boundaries exist (defining a fourth range of p) for which the newspaper has
economic incentives to investigate, merely to insure against potential liability. This
region only exists when investigation costs are low.
Under negligence the expected value from investigating and publishing after an
investigation signals the story is true is given by20
(6) EVn(Investigation) = p(\ - a)v - (1 - p)?(d) - C

Thus like strict liability standard, there is a lower bound (p?) and an upper
bound (pn% under negligence, that determine whether a story is killed, investigated,
or published. The lower bound is obtained by equating equation (6) with the
expected value of killing the story. The upper bound is found by equating equations
(6) and (2).
As shown in Figure 4, all stories with a probability less than pn' are killed without
investigation. When investigation costs exceed a threshold value C", stories with

Publish Without
Investigatijon
Publish
Regarpless

Pete's

Figure 4. Actions of the newspaper under negligence. The figure summarizes the optimal actions of the
newspaper regarding a story with a probability (p) of being true. The newspaper's action is determined by
the relationship of p to the four probability bounds Pn,pn-ib"> p" > and Pw> andthe cost ofthe investigation
(O relative to the threshold value C. No investigation occurs for C>C?".

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 Manoj Dalvi and James F. Refalo
An Economic Analysis of Libel Law

Publish)
if True I

Figure 5. The "Insurance Effect." If investigation costs exceed C the newspaper on

that require a true signal to be published. Thus, the newspaper only publish
investigation, or that have been signaled to be true. The boundary pn" separates tho
the cost is below C, it will investigate stories that it is certain to publish, betwee
stories with probabilities above p?" are published without investigation, the newspap
region between pn" and pn'" only to gain liability protection.

probabilities between pnf and pn" are investigated and published if

signals that the story is true, and stories with probabilities gre
published without investigation. The bounds derived under neglig
those of strict liability (and, in fact, are wider), but the pap
qualitatively the same.
However, unlike strict liability, when the cost of investigation is
an additional region where the newspaper investigates and publi
the investigation signal. This region is defined by the boundspn,f/
in Figure 5.
Since stories with probabilities greater than pn" are published w
tion, the newspaper investigates a story in the region betwee
because the cost of investigation is less than the expected liabili
publishing a false story,21 and because it can eliminate that liabilit
and receiving a true signal. This sole benefit causes the newspap
stories in this region to "purchase" the liability protection
"insurance" value. The intuition is that the newspaper "buys"
insurance is "cheap."22
In the region abovepn-ib" and belowpn", the newspaper publish
investigation results for a different reason. It publishes a story w
because the marginal expected benefits from publishing on a false
marginal expected damages.23
The expected value of investigating and publishing regardless of
signal is given by

(7) EVn(Publish Regardless) =p(l ? oc)v ? (1 -p)?(d)

+p*v - (I - p)(l - ?)
(d + ?>/)- C

The expression for pn-ib" is found by equating equations (6)

solving for p. The expression for pnfff is similarly found by equatin
(2), and solving.
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Derivation of these critical values is presented in the appendix; the results are
summarized in the following proposition:

Proposition 2 Assume that the newspaper is subject to a negligence standard.

There is an upper bound on the cost of investigation (C?"), beyond which it is
sub-optimal to investigate. There is also a lower bound (C < C?"), below which
the newspaper will investigate stories that it will subsequently publish regardless
of the investigation's outcome. Assume C<C/; there are four probability
boundaries pn' <pn" ^pn-ibf" <pnf", such that:

(1) The boundariespn-ib" andpnm converge at C, which is wherepn-ib" ends and

p?" begins. Likewise, pnf and pn" converge at Cnff.
(2) The newspaper will kill all stories when p<pnf.
(3) If C<C, the newspaper will: publish a story without investigation, for
p>Pn", investigate and publish regardless of investigation results, for
Pn-ib1<p<p,n', investigate and publish (only) when the investigation indicates
the story is true, for pnf <p<pn_ibm.
(4) If C <C<Cn", the newspaper will: publish a story without investigation, for
p>Pn\ investigate and publish (only) when the investigation indicates the
story is true, for p? <p<pn".

Proof See the appendix.

Comparison of standards
Figure 6 compares the actions of the newspaper under the two standards. The
investigation region for negligence completely contains the investigation region for
strict liability. This is because investigation is more valuable under negligence:
investigation is imperfect, and the newspaper is able to eliminate the liability from
publishing a false story by investigating and obtaining a true signal. As a result,
relative to strict liability, the lower bound shifts down because the increased value of
investigation makes it economically feasible to investigate stories with lower

c c; c;
Figure 6. Comparison of liability standards. The investigation
a subset of the region under negligence where stories are i
negligence,pn-ib" andpn'" are an upper bound to the region
if true, and p? is the corresponding lower bound. The upper an
standard are p" and pj, respectively. C and C" are always str
or less than, C.

Eastern Economic Journal

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 vi/ Manoj Dalvi and James F. Refalo
VpT An Economic Analysis of Libel Law
82

probabilities.25 Consequently, there is increased publication of lower probability

stories. (Note: As will be shown, this does not necessarily lead to lower societal
welfare, which is also sensitive to parameter values and distributional assumptions
about p.)
Likewise, the upper bound shifts up under negligence, because investigation
provides liability protection beyond merely discriminating between true and false
stories, which is the sole function of investigation under strict liability. Thus, the
newspaper investigates higher probability stories to gain this added liability
protection. Indeed, when investigation costs are less than C, there is a region
under negligence in which stories are investigated solely to obtain insurance, since
these stories will be published regardless of the investigation results. Thus, for any
set of stories, more low probability stories will be investigated and published, and
more high probability stories will be investigated, under negligence.26 Proposition 3
summarizes these results:

Proposition 3 For any given set of parameters pertaining to a story (v, d, Dh a, ?,

and C), Cn > C". Likewise, the relationship between the probability bounds for
strict liability and negligence can be expressed:
For C<C: thenPn <pj<p"^Pn-ib"<Pn", withpnf" converging topn-ib" at C.
For C <C<Cn": thenPn <Ps <Ps <Pn \ withpj andp" converging at C/, and
Pn and pn converging at Cn".

Proof See the appendix.

WELFARE ANALYSIS
The welfare optimum
Welfare is the net benefit (or loss) to society from publication of a story. If a story is
true, society receives a benefit (V> v). If a story is false, society receives no benefit;
the cost to society is the sum of the damage to society (Ds) and the damage to the
individual (Z)7).27 If an investigation is conducted, the society incurs a cost (Q,
whether or not the story is published.28 The expected welfare is the expected value to
society of a true story less the expected cost to society from publication of a false
story, and any investigation costs.
If society internalizes all the costs and benefits from publishing a story, strict
liability is efficient [Shavell 1980; 1987]. Thus, it is under strict liability that society
computes the lower and upper boundaries (pf and p") to solve for the social
optimum. These boundaries are derived in the same manner as those of the
newspaper under strict liability, except that d?Ds and v=V, and they determine
whether society kills, researches, or publishes a story without research. This is
summarized by the following proposition:

Proposition 4 To maximize expected welfare, society computes lower and upper

probability bounds p' and p", respectively. Society would kill all stories when
p<p\ publish a story without investigation when p>p'\ and investigate and
publish only when the investigation indicates that the story is true, forp' >p>p".

Proof See appendix.

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An Economic Analysis of Libel Law "?TV
83

The expected welfare is

(8) W = j[p{\-*)V-{\-p)?{Ps
p' + Di)-C]f{p)dp
l

+ P"j [pV-il-pHDs + DMfWdp

The first integral is the expected utility from a story that is investigated
and published, p is the probability that the story is true, and 1-a is the probability
that the investigation has correctly signaled that the story is true, l?p is the
probability that the story is false, and ? is the probability that the investigation has
incorrectly signaled that the story is true. The distribution of p is f(p).29 Investigation
costs are incurred over the region p^{p\p") regardless of whether a story is
published.
The second integral is the expected utility from stories that are published
without investigation. If the story is true, society receives benefit V with a
probability p. If a story is false, society incurs collective damages of Ds + Dj
with a probability l?p. Since no investigation has been conducted, no costs are
incurred.
The expected welfare equation differs from the expected value of a story to a
newspaper under strict liability,30 and under negligence. Crucially, the bounds of
integration (pf and p") ? which are the probability bounds ? differ from those of
the newspaper under either liability standard. Since it is the bounds chosen by the
newspaper (not society) that determine which stories are killed, investigated, or
published without investigation, there will be a departure from publication policies
that maximize expected welfare.31

Inherent inefficiencies of agency

Society faces an agency problem because the newspaper computes probability

boundaries that are different from those of society (with the exception of footnote
30). Under strict liability, society's expected welfare is computed by substituting the
newspaper's upper and lower boundaries for its welfare maximizing boundaries.
Sub-optimality results and gives rise to the agency problem if the newspaper's
bounds do not equal pf and p".
Under negligence, the problem is more complex; because the probability bounds
used by the newspaper are dependent on C, it is divided into two regions: C^C and
C<C. If OC, (then like strict liability) pnf and pn" are substituted for society's
lower and upper bounds, and a loss of welfare results if the bounds are not equal in
value to those computed by society.32
However, if C<C, the newspaper carries out an additional action that society
would not ? investigate and publish regardless of the result. It will do so between
the boundaries pn-ib" and pnf". This action is sub-optimal because society
internalizes all costs and does not benefit from the additional liability protection
received by the newspaper. Hence, investigation when publication is certain provides
no additional benefit to society, but creates additional costs.
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*Manoj AnDalvi andAnalysis
Economic James F.Law
of Libel Refalo
84

The resulting welfare equation is

(9) Wn,c<c [p(l _ a)v - (1 -p)?(Ds + D,) - C]f(p)dp

+ / [pV-V-pKDs + DMmdp

-C

The third term of this equation reflects the addition

investigating a story that will be published with certainty,
always less than the social optimum. The reason is, to maxim
of integration for the first two terms of (9) must equal the bou
expected welfare equation, for example Pn?p1 and pn_
negligence, when C<C, we have (8) less the third term
expected welfare is always sub-optimal. A derivation of
appendix.

Welfare comparison
The social optimum does not obtain when boundaries on the welfare equation
(under strict liability or negligence) do not equal p' and p". Thus, specific parameter
values and distributional assumptions (about p) are necessary to determine which
standard provides the greatest expected welfare for a given story. Comparison of
Figures 7a to 6d, and 8a-c, illustrates the conditions for which each standard is best
suited; the figures map the difference in welfare (between standards) as a function of
the indicated axis variables. To avoid introducing additional non-linearities, we
assume that p is uniformly distributed. In general, parameter values are permitted to
range over the unit interval, so as to represent a fraction of the value to society of a
true story (V= 1), as a benchmark.33 Figures 7b and 8b/c contrast these benchmarks
with that for a high-value story (V=2).
Light gray indicates that society's welfare from strict liability equals or exceeds
that of negligence, and dark gray indicates that it is less. Contrasting Figures 7a
and b reveals that higher values of V, Ds (relative to Z>7), and proportional increases
in v and d, lead to a greater range of error rates over which strict liability provides
higher welfare. Figure 7c shows that when v is low relative to d, negligence is
generally superior. Likewise, higher investigation costs tend to favor the negligence
standard (see Figure 7d). Note that in the presence of high investigation costs, high
type 1 and type 2 error rates (high a and ?) result in no investigation being
conducted under either standard. The ravine (in Figure 7d), where negligence is
clearly superior, is bounded in by C" to the right and Cn" to the left. Negligence is
distinctly superior in the ravine, because to the left of C" no investigation occurs
under strict liability, and reflects the greater value of investigation to the newspaper
under negligence.
Comparison of Figures 8a-c reinforces these conclusions. Figure 8b shows the
effect of an increase in V\ Figure 8c illustrates the impact of higher investigation
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An Economic Analysis of Libel Law "TrV
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a Strict Liability Minus Negligence b Stdct Liability Minus Negligence

C Strict Liability Minus Negligence d Strict Liability Minus Negligence

Figure 7. (a-c): Welfare comparison in <x-? space. The difference in welfare between the strict liability
and negligence standards, for p uniformly distributed between zero and one. The parameters (K, Dh C, v,
d) for each graph are (1, 0.5, 0.01, 0.3, 0.3), (2, 0.2, 0.01, 0.4, 0.4), (2, 0.2, 0.01, 0.2, 0.4), and (2, 0.2, 0.1,
0.4, 0.4), respectively. Ds is computed as \-D/, thus, total damages to society equal unity. Light gray
indicates that welfare from strict liability equals or exceeds that under negligence; dark gray indicates that
it is less.

costs ? for either small values of v or d, no investigation is conducted under either

standard.34 In summary, the region over which strict liability is welfare superior to
negligence increases with V and the ratio of Ds to Dj. The region declines as
investigation costs increase.

Use of policy tools and the advantage of strict liability

Without the use of policy tools, the social optimum cannot be assured for either
standard. However, under strict liability there exists an investigation subsidy and
scaling of damage award for which social optimality is consistently achieved, based
solely on V, Ds, Dh v, and J, and does not require knowledge of the investigation
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"?rV An Economic Analysis of Libel Law
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a Strict Liability Minus Negligence b Strict Liability Minus Negligence

C Strict Liability Minus Negligence

Figure 8. (a-c): Welfare comparison in v?d space. The difference in welfare between the strict liability
and negligence standards, for p uniformly distributed between zero and one. The parameters (K, Dh C, a,
?) for each graph are (1, 0.5, 0.01, 0.2, 0.05), (2, 0.2, 0.01, 0.2, 0.05), and (2, 0.2, 0.2, 0.2, 0.05),
respectively. Ds is computed as \-Df; thus, total damages to society equal unity. The light gray region
indicates that welfare from strict liability exceeds that under negligence; the dark gray indicates that it is
less.

error rates, a and ?.35 This solution is not available for negligence and is
independent of distributional assumptions.
Proposition 5a Under strict liability, the socially optimal subsidy and liability
scaling is (l-v/V)C and [v/V(Ds + Dfi-dfilD^ respectively.

Proof See the appendix.36

Under the negligence standard, such a correction is impossible: (1) for C<C\ the
social optimum can never be obtained due to the deadweight loss indicated in (9), (2)
for C^C, the value of a and ? must be known to determine the socially optimal
subsidy and liability scaling. These values place increased informational burden on
policymakers. The latter problem is summarized by the following proposition:
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Proposition 5b Assume a negligence standard, with C^C; the subsidy and

damage scaling that are required for socially optimal publication are sensitive to
values of a and a.

Proof See the appendix.

CONCLUSIONS
This paper studies the decision-making process of a newspaper in publishing a story
about public officials under two liability regimes. It has been established by previous
research that if private and social benefits and costs are equal, then strict liability is the
socially optimal standard. However, we find that because the newspaper does not
internalize all public externalities, neither liability standard will reliably attain the
social optimum, except under special conditions. This deviation in benefits also leads
to an implicit agency problem between the newspaper and society.
We show that under negligence, the newspaper will investigate more low and high
probability stories because of the liability protection that standard provides. This
leads to two inefficiencies: (1) the newspaper may have incentives to investigate and
publish very low probability stories, merely because of its ability to protect itself
from liability; (2) when investigation costs are below a threshold, the newspaper has
incentives to investigate stories that it is certain to publish, merely to gain the
additional insurance value. The latter inefficiency results in a deadweight loss to
society. We also show that by partly subsidizing investigation costs and by scaling
the liability damages, the social optimum can be reliably obtained under strict
liability, without knowledge of investigation error rates. In contrast, we show that
the negligence standard requires knowledge of all parameters, thereby creating
increased informational burden for policymakers.
Finally, one possible extension of the model is to allow investigation accuracy to
vary in terms of its cost. Likewise, the model does not permit investigation accuracy
to vary with likelihood that a story is true. Both extensions would require additional
parameterization. The model also ignores issues of risk aversion; risk aversion will
alter the probability bounds computed by the newspaper. Finally, the model
abstracts from issues of competition. Competition among newspapers for market
share is likely to alter publishing policies, by introducing strategic considerations
requiring a game-theoretic approach. This would be an interesting direction to
meaningfully extend the model.

Acknowledgements

The authors would like to thank Gilbert Skillman and two anonymous referees for
substantially improving the quality of this paper. The first author acknowledges his
debt of gratitude to John Donaldson and Michael Salinger for their encouragement
and guidance. We would also like to thank Chris Stefanadis for his comments on the
paper. We accept responsibility for all the errors contained herein.

Notes
1. Simply for expositional convenience, we will refer to the potential tortfeasor as a newspaper. None of
the arguments are specific to that medium, however.

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*?T\ An Economic Analysis of Libel Law
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2. 376 US 254 (1964).

3. 376 US 254, 279-280 (1964).
4. Associated Press v. Walker, 388 US 130 (1967).
5. While "negligence," "gross negligence," and "actual malice" have different legal meanings, liability
standards based on them have the same basic structure. All three allow for a defense for publishing a
defamatory false statement. It is easier for a newspaper to avoid liability under a gross negligence
standard than under a negligence standard and still easier to do so under an actual malice standard,
but we view these differences as matters of degree.
6. Opportunities provided the individual to avoid the appearance of impropriety are (presumably) not a
serious consideration in formulating libel law.
7. Other examples of models that use the care-activity framework to study the incentives of the injurer
and the victim to reduce losses are: Green [1976]; Diamond [1974]; in the context of medical
malpractice ? Shavell [1978]; Simon [1982]; and Danzon [1990]; product liability ? Oi [1973]; Eppel
and Raviv [1978]; and obtain information about risk [Shavell, 1992].
8. In New York Times v. Sullivan, the Supreme Court said that a major consideration was the "profound
national commitment to the principle that debate on public issues should be uninhibited, robust, and
wide-open." 376 US 254, 270 (1964).
9. Hylton [1996], Posner [1998], and Cooter [2000] argue that when the newspaper publishes a story it is a
public good and are unable to capture the full value of the story it has published. Since they are unable
to capture the full social benefit of their publication, holding them strictly liable will result in a chilling
effect on speech.
Renas et al. [1983] develop a model of a profit maximizing newspaper and analyze how the newspaper
reacts to changes in the liability rules imposed on it. They argue that the newspaper will not behave in
a manner to optimize social welfare and analyze the second-best solutions that will prevail. Garoupa
[1999a, b] address the implications of the tort of libel on political corruption where the media is
powerful enough to influence the electorate.
10. Shavell [1997] studies the divergence between private and social motives to settle lawsuits. He argues
that the distortion arises because of litigation costs that are incurred by both parties, and suggests a
number of remedies to align the private and the social, including litigation subsidies, and fee shifting.
Spier [1997] examines the role of litigation subsidies, punitive damages, and allocation legal costs. Our
paper extends this area of research by exploring how liability standards give rise to distortions, and by
examining the use of policy tools to correct inefficiencies. Also see Calabresi and Klevorick [1985] and
Schwartz [1985].
11. In an effort subsequent to earlier versions of this paper, Oren Bar-Gill and Assaf Hamdani [2003] use a
Baysian approach to analyze optimal levels of verification under libel. Their approach is similar to
that used in an earlier version of this paper. They depart from us by studying optimal levels of
verification and by studying only strict liability. Their findings reinforce ours: policy tools are
necessary to ensure optimal investigation and publishing policies.
12. Hereon, we define this as a story's "probability."
13. The potential stories available to a paper in this model are assumed to be random and exogenous. A
natural extension of the model would be to allow the newspaper to make the population of potential
stories a function of the newspaper's expenditures.
14. We make the simplifying assumption that the courts enforce both standards perfectly. For an analysis
of tort law in which enforcement is imperfect, see Calfee and Craswell [1984]. Extending the analysis
here to allow for imperfect enforcement would be particularly desirable because the ambiguity of
"actual malice" is the basis of one of the major criticisms of the current doctrine. See, for example,
Epstein [1986].
15. We interpret "actual knowledge" that a story is false to mean that the paper investigates the story and
obtains information that it is false. We interpret "reckless disregard" for whether the story is true or
false to mean a failure to investigate.
16. Under strict liability, a newspaper is fully libel for Dr if a story is false, regardless of investigation
signal. Thus, it will not investigate a story that will be published regardless of the investigation result,
because the expected value resolves to equation (2), less the cost of investigation.
17. The first term is the expected benefit from publishing a true story: (1-p)v, multiplied by the
probability the investigation correctly signals that the story is true, 1?a. The second term is the
expected damages from publishing a false story: (\-p)(d+ Dj), multiplied by the probability the
investigation will incorrectly signal that the story is true, ?.
18. This result arises in all "value of information" problems. The paper only incurs the cost of
investigation if the outcome of the investigation affects its actions.

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19. If investigation is too expensive, then there are no probabilities under which investigation is optimal.
The critical value for C is the investigation cost above which investigation does not occur. If C is above
that level, then there is a single critical probability that divides stories that are published without
investigation from those that are killed without investigation.
20. Because the newspaper is absolved of liability, equation (6) is equation (3) less the liability
damages, Dh
21. For example, C<(\-p)?(Ds).
22. The intuition for the "insurance effect" can be observed by adding (\-p)?DI-C, the expected
liability from publishing a false story after receiving a true signal less the cost of investigation (a net
add-back), to equation (2). This yields the expected value of investigating and publishing regardless ?
equation (7).
23. Add poLv-(l-p)(\~?)(d+Dj), the expected value for publishing despite a false signal, to the expected
value from publishing only on a true signal. Therefore, the newspaper publishes on a false signal so
long as pav-(\-p)(\~?)(d+Djy
24. The first two terms of this action are the expected value from investigating and publishing when the
investigation signals that the story is true. The third and fourth terms comprise the expected value
from investigating and publishing when the investigation signals that the story is false.
25. A newspaper, with a sufficiently low d, may have the perverse incentive to investigate stories that it
believes are false (have a low probability of being true), merely to obtain a signal exempting it from
liability. This may explain the behavior of some tabloids, whose circulation appears insensitive to
reputational damage.
26. The reason we differ with conclusions of the standard tort models (which find that negligence and
strict liability are equally efficient) is the imperfection of investigation, and that under negligence, the
newspaper is able to eliminate liability by investigating and receiving a signal that the story is true.
27. V includes the benefits to the newspaper, v, and Ds includes the damages to the newspaper, d, but
excludes/)/.
28. This is the same cost incurred by the newspaper.
29. Since the firm receives a number of stories, it has a prior probability about the truth of each story. We
assume that these prior probabilities are distributed over the interval [0,1].
30. Unless (strict liability only) the newspaper internalizes all costs and benefits to society, for example
v=V and d=Ds.
31. There are respective solution hyper-planes for strict liability and negligence (when C^C) that equate
the newspaper's boundaries with those of society. However, any departure from the required
parameter combinations defining that hyper-plane will result in a sub-optimal level of welfare. Under
negligence, if 0<C<C, optimality is never attained.
32. Structurally, the objective function in the welfare equation differs from that of the expected value to
the newspaper under negligence because society computes its expected welfare by internalizing all costs
? it must include individual damages Di if a false story is published. In contrast, the newspaper
eliminates this cost when it investigates and receives a true signal.
33. a and ? (representing the probability of type 1 and type 2 errors) are assumed to range from 0 to 0.5.
Ds = l?Dj, so that total damages to society always sum to one.
34. Because of perspective, Cn" is on the left and C" is on the right.
35. The intuition behind this subsidy and damage scaling is that the newspaper should bear costs and
damages in the same proportion to benefits as is borne by society.
36. If we can make the assumption that all stories have benefits and damages to the newspaper and society
in the same proportion, then the socially optimal subsidy and damage scaling are dependent only on
investigation cost: (\-K)C and K (respectively), where v/V=d/D = K.

References

Bar-Gill, Oren., and Assaf Hamdani. 2003. Optimal Liability for Libel. The Berkeley Electronic Press,
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Calabresi, Guido., and Alvin K. Klevorick. 1985. Four Tests of Liability in Torts. Journal of Legal
Studies, 14: 585-627.
Cooter, Robert D. 2000. The Strategic Constitution. Princeton: Princeton University Press.
Calfee, John E., and Richard Craswell. 1984. Some Effects of Uncertainty on Compliance with Legal
Standards. Virginia Law Review, 70: 965-1003.

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Danzon, Patricia M. 1990. Alternative Liability Regimes for Medical Injuries. The Geneva Papers on Risk
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Oi, Walter Y. 1973. Economics of Product Safety. Bell Journal of Economics, 4: 3-28.
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Renas, M.Stephen, Rishi Kumar, Charles J. Hartmann, and Donn G. Shankland. 1983. Toward an
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Appendix
DERIVATION OF EQUATION (3)
Let / denote the investigation signal and let S denote whether the story is true (T) or
false (F). If the newspaper investigates, the probability that it receives a true
investigation signal is
P(I = T) =P{I = r|S = T) P{S = T)
+ P{I = T\S = F) P{S = F)
=(l-*)p+(l-?){l-p)
If a story is published, and S ? T, it receives a payoff v, if S = F, it receives a payoff
-(d+Di). If a story is killed, its payoff is 0 regardless of S. Also, if a story is
investigated, the newspaper incurs an investigation cost, C, independent of the
signal. Thus, the expected value from publishing on a true signal (and killing on a
false signal) yields (3). Figure 2 shows the expected value of these actions. The
probability of receiving a false signal and corresponding expected value are
P(I = F) = ap + 0(1-/0

E(False) = ocpv + ?(l -p)(d + DI)

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An Economic Analysis of Libel Law *7r\
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Thus, the expected value of publishing regardless of signal is E(False) + E{True), or

equation (2) ? C. Since (2) is the expected value from publishing without
investigation, it is inefficient under strict liability to investigate and publish
regardless of signal.
Proof of Proposition 1 Under strict liability, a newspaper can choose one of three
distinct actions: kill the story without investigation,^, investigate and publish if the
investigation signals that the story is true, (j>2, and publish without an investigation,
04. We first solve for the probability boundaries separating these actions. Then, to
determine optimal actions of the newspaper, compare the expected values for each
action relative to the regions defined (in the p?C plane) by the boundaries. E
denotes expected value.
Setting (3) equal to 0 and solving for p yields the lower probability bound:

(AD ?(d + D,) + C

K ' Ps (l-a)v + ?(d + Di)
Thus, forp>pj, E{4>2)>E{fa); forp<pj, E{<i>x)>E{<i>2).
Equating (2) and (3) yields the upper probability bound:

(M\ ? (1-/Q(rf+ />/)-C

{ ' Ps av+(l-?)(d + D,)
Likewise, for p >Ps", ?(<?4) > E(<p2); for p >ps", E(<t>2) > ?(<?4).
Since pj and p" intersect, solving pj = p" for C defines an upper bound on C,
beyond which investigation (action <j>2) no longer occurs:

(A3) ^J^L(1-?-?v
Finally, equating (2) to zero determines the boundary governing the actions of the
newspaper for OC/:
d + Di
(A4) pc>c? =v + (J + D/)
Comparing the above inequalities yields for p<pj, (?2 for pj <p<p"\ and </>4 for
p>Pswhen C<C". For C^C/, (j>i for p<Pc>c"s and </>4 for p>Pc>c"s are
obtained. The optimal actions for the newspaper are described in Figure 3.

Proof of Proposition 2 Under negligence, a newspaper can choose from actions

0i?</>2>04? and the additional action unique to negligence: investigate and publish
regardless of the signal, 03. In an approach similar to that used for Proposition 1, we
first solve for the probability boundaries, and then identify the optimal actions of
the newspaper for the regions defined by the probability bounds.
Setting (6) equal to 0 yields the lower probability bound:
(L<\ /_ ?d + C
(A5j P?-(l-a)v + ?d
For/>>/>?', E(4>$> E{4>x)\ for p<pn'9 E{4>x)> E{4>2).
Equating (6) and (2) yields the bound separating </>2 a

(A6) P" = av+{l-?)d + Dl

For p >Pn", E(4>4) > E{4>2); for p<pH", E(4>2) > E{<j)A).
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Equating (6) and (7) yields the bound separating <j>2 and 03:

(M\ n?> {\-?){d + D,)

(A7) Pn-lt-av+(l_?){d + Di)
For/?/>?_?'", E(fc)>E{4>2); forp<pn'", E(<j>2)>E(</>3).
Equating (6) and (2) yields the bound separating $3 and </>4:

(A8) p"=~JdT
For p>Pn'", E(^)>E{h)\ for p<pn"', ?(</>3)>E(<j>4).
Since/??_?"' and/??"' intersect, solvingp?-ib" = p?'" for C defines
on C, beyond which action <j)3 no longer occurs:

(A9) C = av{?Dl)
1 } OLV+(\-?)(d + Dj)
For C<C, Pn" >Pn >Pn-ib'\ where /?/ intersects with pn_lb"
Comparing the inequalities corresponding to (A6), (A7), and (A8),
dominant action when pe (/??_//', pnfff).
For C>C, we have Pn" <Pn" <Pn-ib" Comparing the same ineq
that the actions of the newspaper are completely described by
Likewise, solving p? = pn" for C defines a second upper bound, be
optimal action is $1 for p<pc^c% or $4 for p>Pc^c"?
^-?-^+(1-^,1
v } n v + id + Dr)
Since Cn,f?C >0 , C?" > C. Likewise, since solvingpn-ib" = pn" also yields C, this is
where the boundaries intersect. The newspaper's actions are characterized by
Figure 4.

Proof of Proposition 3 By Propositions 1 and 2, pj </?/, Pn<pn", and, for C<C,

Pn <Pn-ib"<Pn"> Thus, to show that the combined inequalities hold, we establish
the following bilateral relationships:

(a) C/>C/. Proof: C/'-C/X).

(b) pj and ps" intersect to the left of pnf and pn". Proof: Cn" > C/.Let C<C?", for
(b), (c), and (d):
(c) p?">Ps". Proof: Pn"-Ps">0.
(d) pj>pnf. Proof: Since (l-a)v-C/>0, (l-a)v>C. Therefore, psf-pn'>0.
(e) Pn-ib" >Ps\ when (K C< C. Proof: />?_//'-/>/>0.

Proof of Proposition 4 Substituting F for v and D for d into (Al) and (A2) yield the
following optimal boundaries for society:

(All) / ?^ + (1Dl) + C
- a)V + ?(Ds + Dj)

(I - ?)(Ds + D,) - C
(A12)
' ?V + {I - ?)(Ds + DT)
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DERIVATION OF EQUATION (9)

When C<Cthe expected welfare equation is composed of three terms: the first is
the expected welfare from action 02, the second is the expected welfare from 03, and
the third is the expected welfare from </>4:
Pn-lb

(A13) WN,c<c> = P'nf \p(l-a)V-(l-p)?(Ds + nI)-C}f(p)dp

P'n

+ Pn-lb
j p(l-a)V-(l-p)?(Ds + Dj)
+ paV - (1 -p)(l - ?)(Ds + Dj) - Cf(p)dp
l

+ Pnj IpV-il-p^Ds + DjW^dp

Because society internalizes all costs regardless of liability standard, the objective
function of the second term is that of the first term less the cost of investigation. The
equation simplifies to (9).

Proof of Proposition 5a Under strict liability, the newspaper chooses pj and p" to
subject to the subsidy Ss and attenuation of damages y. Define Z= C-Ss, the net
cost of the investigation after receiving the subsidy. Equations (Al) and (A2)
become

(ah) ,; = . M+ + *
(1 -^v + ?id + yDj)

,A1sx (l-?^d + yD^-X

[ ' Ps av + (l-?)(d + yDr)
Let: Ss = (l-v/V)C and y = [v/V(Ds +Di)-d\l/Dj.
Substituting Ss and y into (A 13) and (A 14) yields the socially optimal
(All) and (A12).

Proof of Proposition 5b Define X= C-SN. Under negligence the newspaper

the lower critical probability p?' subject to X; thus, (A5) becomes

fAItt ?' ?d + X
(A16) '^(l-oOv + ZW
Equating (A 15) to (A 10) and solving for SN yields the socially optimal subsidy

<a,7> 5?'(1-l')^);(+z,r+P,)^+j-'+ci-^
This reduces to

(a18) SN = (l-ayB[-dV + v(Ds + Di)] + C

(l-a)V + ?(Ds + Di)
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VfV An Economic Analysis of Libel Law
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To derive the corresponding socially optimal damage scaling, note that (A6) likewise
becomes

(A19) {\-?)d + yNDI-X

{ ' Pn av+(l-?)d + yNDr
Equating to (All), and solving for yN,
_ [qv + (1 - ?)d] [(1 - ?)(Ds + D,) - C] - [X + (1 - ?)d] [aV + (1 - ?)(Ds + D,)]
(A20) JN ~ {\-*)V + ?{Ds + D,)
Therefore, SN and yN are sensitive to the values of a and ?.
Note: Even under the assumption v/V=d/Ds = K,

(A21) SN = {l-K)C-K {l~a)?DlV

[(1 - a) V + ?(Ds + Df)]

Eastern Economic Journal 2008 34

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